Covariance

The covariance is a measure of the degree of co-movement between two random variables. For instance,
we could be interested in the degree of co-movement between the rate of interest and the rate of inflation.
The general formula used to calculate the covariance between two random variables, X and Y, is:

cov[X,Y]=E[(X–E[X])(Y–E[Y])]cov[X,Y]=E[(X–E[X])(Y–E[Y])]

While the formula for covariance given above is correct, we use a slightly modified formula to calculate
the covariance of returns from a joint probability model. It is based on the probability-weighted average
of the cross-products of the random variables’ deviations from their expected values for each possible
outcome. Therefore, if we have two assets, I and J, with returns R i and Rj respectively, then:

σ Ri,Rj=n∑i=1P(Ri)[Ri−E(Ri)][Rj−E(Rj)]σRi,Rj=∑i=1nP(Ri)[Ri−E(Ri)][Rj−E(Rj)]
The covariance between two random variables can be positive, negative, or zero. A positive number
indicates co-movement (i.e. the variables tend to move in the same direction); a value of zero
indicates no relationship, and a negative value shows that the variables move in opposite directions

Correlation
Correlation is the ratio of the covariance between two random variables and the product of their two
standard deviations i.e.

i j i j i j
Correlation(R ,R )=Covariance(R ,R )Standard deviation(R )∗Standard deviation(R )Correlation(Ri,Rj)=Covariance(Ri,Rj)Standard deviation(Ri)∗Standard deviation(Rj)

It measures the strength of the linear relationship between two variables. While the covariance can take
on any value between negative infinity and positive infinity, the correlation is always a value between -1
and +1.

You should note the following:

First, -1 indicates a perfect inverse relationship (i.e. a unit change in one means that the other will have
a unit change in the opposite direction). Secondly, +1 indicates a perfect linear relationship (i.e. the two
variables move in the same direction with the unit changes being equal). If there is no linear
relationship at all, then the correlation will be zero.

Example

We anticipate that there is a 15% chance that next year’s stock returns for ABC Corp will be 6%, a 60%
probability that they will be 8% and a 25% probability that they will be 10%. We already know the
expected value of returns is 8.2% and the standard deviation is 1.249%.

We also anticipate that the same probabilities and states are associated with a 4% return for XYZ Corp, a
5% return, and a 5.5% return. The expected value of returns is then 4.975 and the standard deviation is
0.46%.

Suppose we wish to calculate the covariance and the correlation between ABC and XYZ returns. Then:
Covariance,cov(RABC XYZ ,R )=0.15(0.06–0.082)(0.04–0.04975)+0.6(0.08–0.082)(0.05–0.04975)+0.25(0.10–0.082)(0.055–0.04975)=0.0000561Covariance,cov(RABC,RXYZ)=0.15(0.06–0.082)(0.04–
0.04975)+0.6(0.08–0.082)(0.05–0.04975)+0.25(0.10–0.082)(0.055–0.04975)=0.0000561
i j i j i j
Correlation(R ,R )=Covariance(R ,R )Standard deviation(R )∗Standard deviation(R )Correlation(Ri,Rj)=Covariance(Ri,Rj)Standard deviation(Ri)∗Standard deviation(Rj)

Thus:

Correlation=0.0000561(0.01249∗0.0046)=0.976Correlation=0.0000561(0.01249∗0.0046)=0.976

Interpretation: The correlation between the returns of the two companies is very strong (almost +1) and
the returns move linearly in the same direction.

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Calculate and interpret covariance and correlation.

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